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While I was reading The Number (by Alex Berenson) recently, one line struck me and I realized that I’ve been doing it all wrong. Ok, I don’t need to re-do my whole investment strategy. But I’ve been looking a lot at things like the P/E ratio which is a single number that condenses a lot of information. I would love to buy a solid index with a P/E of 5 and I would stay away from one with a P/E of 30.

That’s a bit too simple though. The book points this out well since it’s all about how investors came to focus on one number, quarterly earnings, and ignore a lot of other information. Investors who see rising quarterly earnings will ignore a lot of other important information that will clearly affect future results. I’ve had a similarly limited focus by looking at the P/E ratio so much.

When a wise investor looks at an individual stock, they will look at not just the current earnings but also the likely factors that will affect future earnings. That’s harder to do at the level of an index since every stock will be affected by different factors. To some extent I have to trust the market price and hope that a slightly high P/E ratio means better prospects for future earnings unless I have reason to believe that it’s just investor euphoria.

This applies to other measures since no single number can be taken on its own. For example a lot of people point to the Shiller P/E ratio (or P/E10, using the last 10 years of earnings) which is well above average for the S&P 500 and may be indicating low returns for stocks. But those 10 years of earnings include a lot of exceptional events such as the U.S. housing bubble and the subsequent crash and recession(s). A few years of lowered earnings could easily push up the P/E10 number even if we are past the point where they will have a significant impact on future earnings.

I don’t know that for sure since I would need to analyze every stock to see how it was affected and what its future prospects are. But if other measures look good, one number that’s out of place could just be an exception rather than a warning sign. This is also a good reason to ignore predictions of doom based on some nutty theory like a 70-year market cycle. Anyone can find one measure that looks alarming. Ironically when all of them look bad and there is a real cause for concern, people are usually looking the other way and don’t notice.

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A popular saying among traders is “Don’t fight the Fed”, implying that when the government decides to do something the market has to follow. This may hold true in some cases but once in a while the market demonstrates the limits of government power. For example, two decades ago traders including George Soros forced the Bank of England to break its exchange rate commitments by proving that they were unsustainable.

Another case is unfolding now as the EU’s carbon trading system is having unanticipated effects. The plan was supposed to discourage carbon emissions. But according to the numbers in this article the prices of carbon permits have fallen by as much as 87% which isn’t likely to strike fear into the hearts of big polluters. As a result EU politicians are now trying to manipulate the market by reducing supply.

This may work but it also goes against the principles of the system. Establishing an open market for something that doesn’t show up in a normal accounting of costs is supposed to lighten government regulation since we don’t care what companies are doing as long as they pay the market price to do it. In the process carbon permits will become a new commodity since they will be an essential input for manufacturers in regulated countries.

That means the market may be volatile and unpredictable at times like all commodity markets. And when governments intervene to smooth out volatile markets they can have unexpected effects. After all Alan Greenspan declared that he had smoothed out the business cycle and reduced recessions… we know how that turned out. This type of intervention is more likely to complicate things than make them better, unless the market was poorly-planned in the first place and this is the least bad way to fix it (possible, but I don’t know enough about the market).

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I was reading “The Number” the other day, which is a great account of stock market history and distortions in the 20th century, and I noticed that it described the crash of 1929 by saying “the market was overwhelmed with sellers”. This is how we usually view things: when lots of people sell a stock the price goes down, and when lots of people buy it the price goes up. This is wrong. If you sell a stock, someone has to buy it. If you buy a stock, someone has to sell it. So on any exchange on any day the number of shares sold is exactly the same as the number of shares bought.

If this is true (it is) how do prices go up and down? This is purely a reaction to the thoughts and willingness of investors and traders. Let’s say I own a share of Blackberry and you don’t. I’m interested in selling it and you’re interested in buying it. I won’t sell it for anything less than $15, and you won’t buy it for anything more than $14. Clearly we can’t make a deal here.

Now let’s say Billy-Bob also owns a share of Blackberry. Initially he’s like me, but then he gets food poisoning and suddenly decides that the future prospects aren’t so bright. He’s willing to sell his share for as little as $13 now. You buy his share and you both walk away happy that you got a good deal.

So a more accurate description of how prices go down would be more like this (I’m sure it’s still not the literal truth). At first there are buyers and sellers in the market who can agree on a price, so they trade. After enough of these trades those buyers and sellers leave the market because they got what they wanted. Now the only buyers left in the market are unwilling to pay the previous price. Seeing this, some of the remaining buyers start to leave and the price that sellers have to accept to make a deal goes down. Soon a few sellers decide that they are willing to accept that, so they make a deal with the remaining buyers. Other buyers see this and say “hey, I’m not paying this much if prices are on the way down!”. Once again the demand shifts to a lower price. The most desperate sellers agree to this price so the stock continues to go down.

This keeps happening until buyers get less demanding or sellers get less desperate. Any time there is a gap the sellers can close it by accepting a lower price or the buyers can close it by accepting a higher price. The price of the last trade is what gets reported so we always see the effect of the least demanding buyers and sellers. But that trade was based on one share being sold and bought. We can never say that “today 200,000 shares were sold but only 100,000 were bought, driving the price down”. The number of trades on any day does not determine the direction of the price. All that changes is that people decide they are suddenly willing to accept more or less than yesterday’s price even though they weren’t interested in that yesterday.

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Nassim Nicholas Taleb is a great writer and his first two popular books, Fooled by Randomness and The Black Swan, exposed a lot of people to new ideas. I’ve seen some people writing about changing their investment strategies based on what he writes because of his background as a successful trader. I would be very cautious about this. Although the books are entertaining and thought-provoking, applying the advice too liberally may be dangerous.

The main idea that investors seem to latch on to is what he calls the “barbell” investment strategy. Since I’m reading his latest book now I’ve recently been exposed to yet another description of it. The plan is simple: put 90% of your portfolio in the safest assets you can find to eliminate the downside, and then put the remaining 10% in the riskiest assets you can find to get a profit. He claims that other “blended” or “balanced” strategies have hidden risks of great loss and this avoids them.

Ironically many people who end up following this advice are exposing themselves to unexpected negative surprises (black swans). It comes on both sides. First, the safe asset may not be safe. As Taleb wisely and repeatedly points out we assume that the past will repeat itself. The US government has never defaulted on short-dated treasuries… yet. Who knows if they will be safe in the future? But that’s only a minor technicality.

The real danger is in the risky portion of the assets. Many people seem to be building a portfolio where they assume the risky assets will make them a lot of money. This is a bit ironic – “Hey, I have this great high-risk investment that’s guaranteed to make a good return!”. Either they are doing very badly at picking risky assets or, if they do it correctly, they have a very high chance of losing that 10% of their portfolio.

So once that happens the plan has worked. You’ve lost 10% of your assets and the other 90% are safe (we hope) in an investment that is generating minimal returns if any. Now what? If you’re like most investors you expect to earn a higher return than that. So you need to start over, and take 10% of your remaining 90% and put it into risky investments. Do this 5 times in a row and you’ve lost 41% of your portfolio. How’s that for risk-free?

The misconception here lies in applying this to your current portfolio. If you have $100,000 invested and you have determined that you need $1,000,000 to retire comfortably, that means that the amount you cannot afford to put at risk is 90% of that or $900,000. But if you implement this strategy with your portfolio today you will be keeping $90,000 safe, which is far short of your needs, and risking $10,000 which you can’t afford to lose yet.

Your financial life can play out in one of two ways: either you can directly save enough cash to pay for your living expenses when you aren’t working which means your only goal is to avoid losing that while making a minimal return. Or you can’t save that much, which means your only hope of success is to earn a decent investment return. Many people fall into the second category (to break the mold I put myself in the second category but could make the first work). This leads to the great misunderstanding of risk. The biggest risk for them is that they don’t get the investment return they need. If they merely hold on to the cash they have saved, they will have failed.

For that type of person the safest strategy is to create a balanced portfolio that will give them the return they need while minimizing the risk of total loss and the volatility along the way. Once you have enough money then you can switch to a preservation portfolio. So it turns out that the brilliant new black swan strategy is just old common sense: when you have enough already, don’t put it at risk in the pursuit of further gains that you don’t need. And it didn’t even take me a whole book to explain that!

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These days it’s hard to be a stock market optimist. As the Canadian Couch Potato points out, people are scared of stocks whether the market is up or down. Everyone has a half-baked idea about how some economic indicator is forecasting doom. One of these has actually gotten my attention at times. With the policies of central banks driving down interest rates, are they causing the prices of assets (such as stocks) to rise to unsustainable levels and lowering future returns?

This is entirely possible since low interest rates make the economy look good, help companies make more profits, and allow investors to borrow to buy stocks. Rising interest rates give you the opposite of those effects. So there is a reason to be cautious.

However after looking at other information this is far from a clear picture. First, the valuations of stocks are reasonable. If the P/E ratios of major indexes were pushing above 25 that would be a real cause for concern, just like when buying a house is unaffordable compared to renting (see: Vancouver). But we’re nowhere near that point yet.

Second, as the post linked above points out investors continue to flee stocks. And they’re still buying up bonds that pay an insultingly low yield, even a negative real yield in many cases and a negative nominal yield in a few cases. It seems like this is perhaps a bigger driver of the market right now. With everyone trying to rush for the exits in the stock market, we would still be in the middle of a big asset crash. Central bank policies may be propping up the stock market but I don’t think the effect is unreasonable at this point (I wouldn’t argue with a nice 50% crash next month of course).

If the economy recovers to a state similar to where it was 10 years ago, the central banks may be able to quietly withdraw the pressure they’re applying now without disturbing the balance, once investors are confident enough to support assets prices on their own. Or if we move permanently to a new, lower level of growth, asset prices might just stagnate or slowly decline as the central banks keep intervening.

Either way I still believe there’s a good chance that at some point in the next few years investors will flip a switch and pour massive waves of cash back into the stock market (well after it’s recovered of course), driving prices to true bubble levels.

Let’s hope bonds crash before then so there’s at least one good asset class to move into.

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About This Blog

This is where I write about investment/finance ideas and useful information I come across as I refine my personal investment plan. I also write a more general blog about creating and enjoying wealth at Simply Rich Life. Check it out!